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Econ 101E (Module 5) Hand-Out Basic Economy Study Methods 1st Sem 2020-2021
Econ 101E (Module 5) Hand-Out Basic Economy Study Methods 1st Sem 2020-2021
2. Present Worth (PW) Method –based on the concept of equivalent worth of all cash flows
relative to some base or beginning point in time called the present. All cash inflows and
outflows are discounted to the present point in time at an interest rate that is generally the
MARR.
PW(i%) = F0(1 + i)0 + F1(1 + i)-1 + F2(1 + i)-2 + ….. + Fk(1 + i)-k + . .
+ . . . . . + Fn(1 + i)-n
where: i = effective interest rate, or MARR, per compounding period
k = index for each compounding period (0 ≤ k ≤ n)
Fk = future cash flow at the end of period k
n = number of compounding periods in the planning horizon
(i.e., study period, service life, etc.)
The PW of an investment alternative is a measure of how much money an
individual or a firm could afford to pay for the investment in excess of its cost.
Conditions: a) If Net Present Worth, NPW ≥ 0, project is justified economically.
b) If only outflows (disbursements) are considered, the method is
characterized by negative-value present worth and can be expressed as
present worth-cost(PW-C). A low-valued NPW-C is preferred to a high-
valued NPW-C.
Example 2) A piece of new equipment has been proposed by engineers to increase the productivity
of a certain manual welding operation. The investment cost is $25,000, and the equipment will have
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a market value of $5,000 at the end of a study period of five years. Increased productivity attributable
to the equipment will amount to $8,000 per year after extra operating costs have been subtracted
from the revenue generated by the additional production. If the company’s MARR is 20%, is this
proposal acceptable?
CFD: A A A A A = 8,000
Sv = 5,000
1 2 3 4 5
I = 25,000
i = 20%
Solution:
NPW = PWI + PWA + PWSv
NPW = I + A [(1 + i)n – 1] + ___ Sv___
[ i (1 + i)n] (1 + i)n
NPW = - 25,000 + 8,000[(1.20)5 – 1] + _ 5,000_
[0.20(1.20)5] (1.20)5
NPW = 934.28 > 0, therefore investment is acceptable.
3. Future Worth(FW) Method - based on the concept of equivalent worth of all cash flows at the
end of the planning horizon( study period) at an interest rate that is generally the MARR.
FW(i%) = F0(1 + i)n + F1(1 + i)n - 1 + F2(1 + i)n - 2 + ….. + Fk(1 + i)n - k + . .
+ . . . . . + Fn(1 + i)0
where: i = effective interest rate, or MARR, per compounding period
k = index for each compounding period (0 ≤ k ≤ n)
Fk = future cash flow at the end of period k
n = number of compounding periods in the planning horizon
(i.e., study period, service life, etc.)
The FW method is very useful in capital investment decision situations because the
primary objective of all time value of money method is to maximize the future wealth of
the owners of a firm.
Conditions: a) If Net Future Worth, NFW ≥ 0, project is justified economically.
Example 3) Given the previous example IV.2, is this proposal acceptable using NFW method?
CFD: A A A A A = 8,000
Sv = 5,000
1 2 3 4 5
I = 25,000
i = 20%
Solution:
NFW = FWI + FWA + FWSv
NFW = I(1 + i)n + A [(1 + i)n – 1] + Sv
(i)
NFW = - 25,000(1.20)5 + 8,000[(1.20)5 – 1] + 5,000
[0.20]
NFW = 2,324.8 > 0, therefore investment is acceptable.
4. Annual Worth(AW) Method – similar to PW and FW except that cash flows are in
equal/uniform annual series of amount.
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The AW of a project is an equal annual series of amounts for a stated study period that is
equivalent to the cash inflows and outflows at an interest rate that is generally the MARR.
Sv = 5,000
1 2 3 4 5
I = 25,000
i = 20%
Solution:
NAW = AWI + AWA + AWSv
NAW = I [i(1 + i)n ]_ + A + ___Sv( i )___
[(1 + i)n – 1] [(1 + i)n – 1]
NAW = - 25,000[0.20(1.20)5] + 8,000 + __5,000(0.20)
[(1.20)5 – 1] [(1.20)5 -1]
NFW = 312.4 > 0, therefore investment is acceptable
Sv = 5,000
1 2 3 4 5
I = 25,000
Solution:
PW cash inflows = PW cash outflows
PWA + PWSv = PWI
A [(1 + i’)n – 1] + ___ Sv___ = I
[ i'(1 + i')n] (1 + i')n
8,000[(1 + i)5 – 1] + _ 5,000_ = 25,000
[i'(1 + i')5] (1 + i')5
By trial and error (or spreadsheet solution)
i’ ≈ 21.6% > 20% (MARR), therefore project is economically justified.
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6. External Rate of Return(ERR)
This method directly takes into account the interest rate (Є) external to a project at
which net cash flows generated or required by the project over its life can be reinvested or
borrowed. If this external reinvestment rate, which is usually the firm’s MARR, happens to
equal the project’s IRR, then the ERR method produces results identical to those of the IRR
method.
Steps for computation:
1. All net cash outflows are discounted to time 0 (present) at Є%
per compounding period.
2. All net cash inflows are compounded to period n at Є%.
3. The external rate of return, which is the interest rate that establishes equivalence
between the two quantities, is determined. The absolute value of the present
equivalent worth of the net cash outflows at Є% (first step) is used in this last step.
Condition: If Є% ≥ MARR, the project is acceptable.
The ERR method has two basic advantages over the IRR method:
1. It can usually be solved directly, without needing to resort to trial and error.
2. It is not subject to the possibility of multiple rates of return.
Sv = 5,000
1 2 3 4 5
I = 25,000
Solution:
FW cash outflows(at Є%) = FW cash inflows(at MARR)
FWI = FWA + FWSv
P(1 + Є) = A [(1 + MARR)n – 1]
n
+ Sv
(MARR)
25,000(1 + Є)5 =8,000[(1.20)5 – 1] + 5,000
(0.20)
Є = 20.88% > 20% (MARR), therefore project is economically justified.
7. Payback/Pay-out Period – is defined as the minimum length of time theoretically necessary to
recover the original capital investment in the form of cash flow to the project.
a. Simple Payback period – ignores the time value of money.
Payback Period = __Capital Investment__
(in years) Cash flow/year
b. Discounted Payback period – takes into account the time value of
money at interest rate, i.
Sv = 5,000
1 2 3 4 5
I = 25,000
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a) What is the simple payback period?
b) What is the discounted payback period if the company’s MARR is 20%?
Solution:
a) simple payback period
Payback Period = __Capital Investment__
(in years) Cash flow/year
Payback Period = __$25,000_
(in years) $8,000year
Payback Period = 3.125 years
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Solution:
Using Conventional B-C ratio with PW:
PW(B)_______________
B-C =
I−PW(MV)+PW(O&𝑀)
A [(1 + i)n – 1]
= ___________[ i (1 + i)n]______________
I - ___ MV___ + O&M __[(1 + i)n – 1]__
(1 + i)n [ i (1 + i)n]
8000 [(1 + .15)5 – 1]
= _________[ .15 (1 + .15)5]______________
10000 - ___ 1000___ + 4000 __[(1 + .15)5 – 1]__
(1 + .15)5 [ .15 (1 + .15)5]
B–C= _______26,817.24_________
10,000 – 497.18 + 13,408.62
Practice Problems:
1. A company is planning to purchase a new machine for Php600,000. The machine is
expected to generate a net cash flow of Php150,000 annually for six years which is the
estimated service life of the machine. What is the rate of return of the initial investment?
a) 17.5% b) 20% c) 22.5% d) 25%
2. Determine the PW of the following engineering project when the MARR is 15% per
year. Is this project acceptable?
Investment cost = $10,000
Expected life = 5 years
Market (salvage value at end of life) = $1,000
Annual receipts = $8,000
Annual expenses = $4,000
a) No, NPW = -$7,492 b) Yes, NPW = $3,906
c) Yes, NPW = $4,409 d) No, NPW = -$3,906
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4. A company invested a certain amount in an 8-year project. It expects a net cash flow of
Php200,000 per year for the first 4 years and Php150,000 in the last 4 years of the project
life. If the investment was based on MARR of 12%, how much was the investment?
a) $897,013 b) $958,732 c) $992,209 d) $841,515
6. The construction of the a bypass is P800,000,000 and P20,000,000 would be required each year for
maintenance. The annual benefits to the project have been estimated to be P80,000,000. The study
period(estimated life) of the project is 50 years.
6.1 (5 points) Using Modified Benefit-Cost Ratio method with PW and an MARR of 8% is this
project acceptable?
a) Yes, B-C Ratio is 1.4 b) No, B-C Ratio is 0.85
c) Yes, B-C Ratio is 1.1 d) No, B-C Ratio is 0.92
6.2 (5 points) Using Modified Benefit-Cost Ratio method with PW and an MARR of 4% is this
project acceptable?
a) Yes, B-C Ratio is 1.6 b) No, B-C Ratio is 0.85
c) Yes, B-C Ratio is 1.1 d) No, B-C Ratio is 0.94
References:
1. Blank, L., & Tarquin, A. (2018). Engineering Economy (8th ed.). McGraw-Hill Education.
2. Sullivan, W. et al, (2015). Engineering Economy (16th ed.), Pearson Education-South Asia Pte. Ltd
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